Why ETFs Lag Their Indexes

Some Investors Who Bet on a Bounce in Japan Lost Out; Shades of 'Flash Crash'

By

Sarah Morgan

Updated April 16, 2011 12:01 a.m. ET

The Japanese stock market has rebounded smartly since the earthquake struck on March 11. But many investors who used exchange-traded funds to capture those gains may have been sorely disappointed.

Since a March 15 low, the three U.S.-sold ETFs that track the broad Japanese stock market all have lost money, even though the indexes they mimic are up. The largest, the $7.2 billion iShares MSCI Japan Index ETF, has lost 0.6%, even though the MSCI Japan index, which the fund tracks, is up 5.3%. Similarly, the $108 million iShares S&P/TOPIX 150 ETF is down 1.32% while its index is up 8.6%, and the $15.2 million SPDR Russell/Nomura PRIME Japan ETF is down 0.78%, while its index is up 6.6%.

This is fairly common for ETFs that track small, thinly traded "frontier" markets such as Egypt or Vietnam, says Patricia Oey, an ETF analyst at investment research firm Morningstar Inc. But as recent events show, such price divergence also can be a hazard for ETF investors even in markets like Japan, which is among the biggest and most liquid in the world.

ENLARGE

Houses overtaken by flooding and fire in the northeastern Japanese city of Natori, in the wake of last month's massive earthquake and tsunami.
Reuters

Blame it on the structure of ETFs, which typically track a market index and trade throughout the day like stocks. The market price of a fund is supposed to mirror the value of the underlying stocks in the index, called the "net asset value." But sometimes the two prices diverge widely; if the price is higher than the NAV, investors are essentially paying a premium.

That is because the NAV of an ETF is usually set at the end of each local trading day. But those ETFs then trade all over the world, often while the local markets are closed. That was the case in Japan, where stocks experienced increased volatility in the weeks following the earthquake and the trading prices for iShares' Japan ETFs moved further than usual from their NAVs, says Paul Lohrey, a spokesman for iShares.

When that happens, the ETF's price represents the most current fair-market value for that basket of stocks, more up-to-the-minute than the NAV, Mr. Lohrey says. In fact, the price discrepancy did disappear relatively quickly, though investors who paid a premium may still be in the hole.

Though such a severe price differential is technically possible anywhere, it is rare for it to happen in such a big market, and repeatedly, over such an extended period. During the U.S. "flash crash" in May 2010, a number of ETFs briefly traded at steep premiums to their NAVs.

Some money managers see it as a risk worth taking. "We've all got to be big boys and girls if we're going to be in international markets," says Herb Morgan, the chief investment officer for Efficient Market Advisers, which uses ETFs to build client portfolios.

Mutual fund investors are protected from the tracking problem. Like ETFs, mutual funds carry an NAV based on the underlying holdings of the fund and set once a day when the market closes. But because the market price of a mutual fund doesn't fluctuate during the trading day, investors only ever pay that day's NAV. There is no chance of a premium (or a discount) that would distort returns over time.

So investors who bought shares of, say, the $582 million Fidelity Japan fund at its March 16 low would today be up about 4.5%. But the fund wouldn't have suited many short-term traders: It imposes a 1.5% redemption fee for shareholders who sell within 90 days.

The problems with Japan ETFs were not the first of their kind—not even this year. Investors who may have hoped to make a killing following the turmoil in Egypt in February may have yet to break even, let alone realize the profits from that market's rebound.

The premium on the $57 million Market Vectors Egypt Index ETF rose to as high as 24.5% on March 8; investors who bought on that day would be down 13.3% today, even though the value of the underlying shares has risen nearly 5%.

The unrest in Egypt left its markets closed, meaning that Van Eck Global, which manages the Market Vectors ETF, couldn't create any new shares to meet new demand. The ETF began to trade like a closed-end fund—with a finite number of shares available.

As demand rose, the premium rose, until Egyptian markets reopened and the fund was able to create more new shares, says Edward Lopez, a spokesman for Van Eck. Today the premium is about 0.6%, which is far more reasonable for small, emerging-markets ETFs, says Morningstar's Ms. Oey.

To minimize the risk of overpaying for an ETF, Ms. Oey recommends investors compare the ETF's current premium or discount to historical data and avoid buying at a greater-than-average premium. (Current and historical data is free on Morningstar.com's ETF quote pages.) The key for investors isn't how much the premium is in absolute terms, but whether it shrinks while you are holding the ETF.

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